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April 29, 2014

Flat Fees or AUM, the Final Chapter (Maybe): The Retired Client

One of the reasons that I’m not a big fan of social media discussions like those on Twitter is that they feel like “drive-by” thinking to me: First, someone posts one or two sentences about a complex topic (such as flat advisory fees) mostly with the intent of swaying others to recognize the righteousness of the writer’s point of view. Then, a few other folks post one-sentence comments that either agree with the original statement (which get “liked” and praised) or disagree—and are dismissed with hit-and-run comments that question the poster’s credibility. Maybe it’s my training in philosophy, but this doesn’t feel like real thinking to me: which involves considering new information and other points of view in order to make our own ideas better.

A good example of how a beneficial discussion can work to advance the discussion is the comment posted by Elliott Weir of III Financial about my last blog (April 16, Flat Fees or Fees on AUM, Take 4: The Sweet Smell of Success), which was the fourth installment in an ongoing discussion about the relative merits of flat fees vs. AUM fees). Elliot has posted insightful comments to each of my blogs on flat fees, but his latest posting is perhaps the most important comment that I’ve seen or heard from anyone on the subject, and has indeed broadened my thinking: “One additional downside to the AUM pricing model is that, if you focus on the retiree market as I do, tying yourself to account value while periodic withdrawals are taken almost guarantees a ‘reduction’ in fees over time. Am I adding less value because my clients are enjoying their money, possibly paying off a house or buying some guaranteed income?”

Folks have mentioned the conflict that arises in the AUM fee model when clients want to take money out of their investment portfolio to pay off their houses, but in today’s low interest rate environment (which is deductible), paying off the mortgage probably isn’t going to pencil for most people anyway. However, the issue raised by Mr. Weir of declining AUM fee income as more clients enter their depletion phase clearly warrants serious consideration.

Much has been written recently about the need for attracting younger clients to offset the economic effects of aging client bases—primarily lower fee incomes and firm valuations. Yet few observers stop ask how big a problem this really is. The best analysis I’ve seen on the subject recently comes from Michael Kitces in his March 27, 2014 ThinkAdvisor blog, Your Clients Are Getting Older. So What?

Here’s what Michael had to say on the subject: “The reason that retirement withdrawals are not all that destructive is the simple fact that in the early stages of retirement, withdrawals relative to total assets tend to be rather modest… …as evidenced by the fact that withdrawals start at a rate (6.6%) that is less than the growth rate (8%), on average a retiree at age 60 doesn’t actually begin to deplete the account balance at all until almost halfway through retirement. It’s only by the client’s mid-70s that the account balance even begins to decline, and several more years after that before it dips below where it started, and only then finally experiencing the rapid spend-down in the later years.”

This is a vastly different picture of the impact of aging clients than we normally get: and a more encouraging one. It also suggests, at least to my mind, that once again, the advantages of the identity of interest between client and advisor created by AUM fees outweigh the potential conflicts: an advisor’s success at growing the client’s portfolio can delay a decrease in compensation for many years. And good portfolio performance could go a long way toward insuring a continuing relationship with the surviving spouse.

Flat fees, of course, would solve the declining revenue problem altogether—and eliminate conflicts over any drawdowns of client portfolios, including gifting, trust funds, second homes, etc. Personally, I like the idea of AUM success fees. But that’s just my opinion: I could be wrong. If I am, I hope some of you will further the discussion and tell me why.

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